Double-Digit Dividend Growth ETF Concept

10%+ Annual Raises

Small raises may keep pace with inflation, but big raises propel you forward, opening doors to new opportunities, higher standards of living, and greater financial security. I like to view the estimated annual income of my stock portfolio like my annual salary. There are investors out there netting $100k/year in dividends with a 13% annual raise incoming while a worker is joyful to receive a 3% raise on their $50k/year salary to combat inflation, if that. As a dividend investor, I think differently about what money is worth. That $15/month subscription is actually worth $4500. That $400/month car payment is worth $120k. A $100k/year salary is worth $2.5M. I’m just multiplying the annualized value by 25 (4% rule) to reflect how much money you’d need to invest to cover these bills/income to guide what your portfolio goals could be. For any income-dividend investor, simply divide your monthly income requirement by your portfolio yield and annualize it to determine how large you need to scale your portfolio.

I’ve been intrigued with a thematic investment approach of double-digit dividend growth (DDDG) stocks which consistently grow their dividends by 10% or more annually. I covered MSCI Inc.’s (MSCI) dividend growth recently as the top double-digit dividend growth stock in the month of January 2024 and have covered several other stocks and ETFs which present double-digit dividend growth as well, such as Schwab U.S. Dividend Equity ETF (SCHD) and iShares Core Dividend Growth ETF (DGRO). Imagine assembling an ETF with only like-minded stocks: compounding your annual income higher and higher. I searched Seeking Alpha, the web, and investment companies for a fund like this and found there is no index fund or ETF in existence with this thematic approach of double-digit dividend growth. Not all high-pay raisers perform well, but the ones that do seem to provide an avenue for alpha dividend growth, the goal is to be on the higher side, say 15%+. The fund proposal in this article presents a 5-year past performance of over 17% average annual dividend growth.

Screen Setup & Results

There are many variables and constraints one could manipulate to form this fund. In order to explore such a topic, decisions and assumptions have to be made to keep things contained. Besides, most things are not driven by 10 factors, but rather only a few vital ones, as the Pareto principle has proven over and over. I’m not suggesting this is the optimal portfolio, but feel the criteria are appropriate, and I would personally invest based on the results presented.

The key criteria to screen for DDDG stocks are the following:

• United States.
• Payout Ratio < 60%.
• Years of Growth > 5 Years.
• Consecutive Years > 5 Years.
• Dividend Growth 5Y > 10%.

This screening resulted in 165 holdings with household names like Visa Inc. (V), Microsoft Corporation (MSFT), and Costco Wholesale Corporation (COST) among the ranks. Below is the complete list of results:

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I then took an average of the key performance metrics of all 165 holdings, equally weighted:

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This screening methodology drove healthy averages across the portfolio: a yield around 2%, a wide-moat payout ratio < 30%, and a 5-year dividend growth rate of over 17%. For reference, this fund’s 5 and 10-Year Total Returns are 125% and 377% vs. 101% and 226% of the S&P 500 respectively. Similar to SCHD’s methodology, I’d like to only select the top 100 stocks from this screen, but am need to explore the best performance metric to prioritize.

The Top 100 Stocks by Performance

We want high yield, dividend growth, and total returns, but we can’t have it all. I ran three permutations to select the top 100 stocks, again equally weighted, in order of the highest metric categories:

• Yield TTM.
• 5-Year Dividend Growth.
• 5-Year Total Return.

Of note, this fund’s concept could be arranged by > 5 years total return due to the screening methodology set up to only select stocks with 5 years consecutive & growing dividend history.

The underlying battle here is that double-digit dividend growth stocks tend to have lower yields than something like SCHD, so we need to determine when the yield on cost (YOC) breaks even, otherwise, there is no alpha for income investors. However, while we are seeking high income and dividend growth, we cannot ignore total return either. In the chart below, I superimposed three different YOC profiles with different prioritization of the top 100 stocks by the various performance metrics. Of note, these are simple projected estimates using the current 5-year dividend growth output from each scenario and annualizing it continuously, real performance may vary in the future.

Prioritizing by the highest 5-year dividend growth unsurprisingly gave the largest YOC after 30 years and the highest average 5-year dividend growth at 21%, shown in the table below. Interestingly, prioritizing by Yield TTM had a breakeven YOC compared to SCHD about 1 year sooner than prioritizing by 5-year dividend growth. However, the higher yield of 2.63% came at a cost to the 10-year total returns at 265% compared to 424% and 489.5% when prioritizing by 5-year dividend growth and total return respectively. By far, prioritizing stocks by their 5-year total returns gave the highest 10-year total return, still with a high 5-year dividend growth rate of 17.5% despite being the lowest yielding fund. Overall, all three funds performed better than SCHD if an investor is willing and able to sacrifice the higher yield.

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Correlations

After reviewing these results, I was interested to do a simple linear regression to see what other variables correlate best to highest 10-year total returns based on

• Payout Ratio TTM.
• Consecutive Years of Dividend Growth.
• 5-Year Total Return.

For linear regression models, an R-squared value > 0.80 is typically acceptable to state there may be correlation, but there are always exceptions. You can think of the R-squared as saying what percent of the variation in the input x-variable explains the output or y-variable of the 10Y Total Returns.

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While none of the regressions explain the variation in 10-year total returns well enough to say “there’s correlation”, the 5Y total return did explain 71% of it. The model would fit better without some of the exceptional outliers, but I cannot remove them as this is the nature of investing in stocks. It’s also interesting to note that above a 50% payout ratio, there’s a concentration of returns < 500% whereas below 50% payout ratio seems to give businesses leeway to reinvest their earnings to significantly multiply returns long-term. Finally, the more years of consecutive dividend growth shows lower but more consistent returns, possibly reflecting that the noble class of dividend paying companies: achievers, aristocrats, and kings have a strong understanding of their business model and return profile.

Risk Analysis

While this portfolio concept performs well, there are numerous risks which need to be addressed before assembling such a portfolio:

• Weighting method could prioritize or partially weigh multiple metrics.
• Portfolio Turnover, particularly when adding or removing a stock which no longer fits the screening criteria.
• What’s the sector diversification of this portfolio? Should there be weighting rules to it?
• Additional scrubbing of holdings to solidify the top 100 stocks, should there be rules to screen out certain high yield values, for example?
• Are the top 100 stocks of the screen optimal? Should it be more or less?
• Would including international stocks add alpha?
• Test of Time: we are only looking at 10-year total returns during a historic bull run era.

While I would feel comfortable investing in the portfolio presented, certainly an investment firm with the capability to manage a fund like this would be preferred, mainly I’m concerned with the turnover in managing the weighting, it is not a tax liability I want to deal with. I would love to hear from readers what other risks they see with this portfolio strategy idea as well.

Moving Forward

Based on the results of this ETF concept, I believe there’s an opportunity for a thematic investment portfolio of high quality companies with double-digit dividend growth. A way to actually assemble a portfolio like this in my case would be to use Fidelity’s Basket Portfolios. It is a newer service exactly for this type of pursuit where individuals can create and automatically invest in their own ETFs. To address my tax efficiency concern, they utilize the “Smart Buy” feature, which automatically buys more of the underweight securities to maintain target weights.

Though as mentioned in the risk analysis, the screening used in this article is just a first pass. I believe the earnings estimates need to be taken into account to ensure this kind of dividend growth is sustainable, prior to a stocks’ inclusion in the fund. Consensus on forward-looking growth prospects, specifically annual EPS growth and forward payout ratios, for each stock in the initial list of stocks or top 100 stocks would be another analysis to run alongside adjustments made to the screening methodology.

While prioritizing the top stocks based on the dividend growth alone did not give the overall best performance, prioritizing by trailing 5-year total return still gave a past performance of 17% 5-year dividend growth along with a 10-year total return outperforming the S&P 500 significantly: 490% vs. 226%. The initial screening methodology clearly shows that companies with consistent double-digit dividend growth and low payout ratios drive excellent stock performance. It isn’t because they give huge raises they perform well, rather the underlying fundamentals of their business create an environment to provide excellent annual raises for investors, propelling them forward toward their financial goals.